What drives value in a business?
Often times when professionals talk about business value, or what a business sold for they talk about it in terms of EBITDA multiples. EBITDA means Earnings Before Interest Taxes Depreciation and Amortization. The EBITDA multiples businesses sell for are usually stated in a range, and the range typically varies by industry. It might be, just as an example, that businesses within your industry sell for 5x EBITDA to 7x EBITDA. The question is, what causes some to sell for 5x EBITDA and another one to sell for 7x EBITDA? There are a number of factors at play, but we will talk about some of the major factors here.
A lot of the items we will discuss concern the perceived risk associated with the business’s future performance. Anyone who has operated a business knows that it is an inherently risky venture. Therefore, anything you can do in your business to reduce the risk to a potential buyer will help to increase the value to that buyer. Another key concept to consider as you think about and begin to prepare your business for exit is the level of autonomy your business has. Basically ask yourself, “can my business operate well without my involvement?” I always tell people that I talk to about preparing their business of exit that, “Nobody wants to buy your job. They can always find a job. They don’t want to buy one.” If your business requires constant attention from you, the owner, or else it will fall apart, that will not be as valuable as a business than can run smoothly with little to no involvement from you. These two key concepts are at the root of almost all the concepts we will explore here. Keep an eye out for them as we cover the specific value drivers and think about how each of the specific drivers connect back to these two overarching ideas.
Also, keep in mind that the value drivers we are discussing today are general guidelines. They aren’t necessarily achievable in all situations. However, just because you can’t achieve one, doesn’t mean you can’t still take steps to show a potential buyer that you’ve reduced risk in that area, which may still make your business more attractive to them.
Markets & Customers
We will begin our discussion reviewing a few items related to markets and customers and thinking about different aspects here that can increase the value of your business to a buyer. First, consider your customer base. How diversified is it?
Do most of your sales come from one or two key customers? If so, this increases risk from a buyer’s perspective because they would see the transfer of ownership as a potential risk to losing one of those key customers which would directly impact the revenues and thus the bottom line. Conversely, if you have a well-diversified customer base where most of your sales come from a large number of different customers, and none of them account for any more than 10% of the business, this is less risky from a buyer perspective.
Another good customer metric that buyers like to look at is, how high is your customer retention rate? Do you have a lot of repeat business? This indicates to a buyer that they will not have to spend as much effort generating new business because there will likely be quite a bit of old or repeat business coming in the door still when they take over. It also indicates that you likely have a high brand recognition and good reputation with your previous customers and within the communities you serve. This is another value driver: high brand recognition & good reputation.
Now let’s take a look at your competitive advantage. Obviously, a business with a clear, sustainable competitive advantage would be more valuable than a business that has no real competitive advantage or a poorly defined one. One thing you can do to help sustain your competitive advantage is to protect your intellectual property through the use of trademarks, copyrights, or patents. You should try to do this for key processes, procedures, or innovations that your company has developed over the years. This obviously will help keep other competitors out of your market and help you further define your reputation and brand. It also helps to create a barrier to entry for other competitors in your market space.
In the same vein, having barriers to entry that keep potential competitors out of your market or operating in a specialized niche market also increases your business value. It means there is less risk of other people coming in and stealing market share or customers away from you.
As we mentioned earlier, nobody wants to buy a messy, disorganized business from you. They do not want to buy a job. They want to buy a well run company. Knowing this, what can we do to increase value? Well, the first thing you can do is make sure that you are documenting your internal operational processes. They should be well written, thorough, and easily available. This not only helps you to train your current staff, but it also enables you to scale up more quickly. These documented procedures include having sound internal policies for HR (along with all appropriate documentation), sales and marketing processes, accounting processes, and any other processes that are critical to delivering your product or service to your customers.
You should also keep a record of past budgets or any other performance management tools that you’ve had in the past, and keep a record of actual performance compared to those targets. Companies that can show the ability to set a target and achieve it along with a strong, positive growth in key metrics over time, will be worth more than companies that do not have such strong, positive trends.
You’ll also want to make sure that your office and/or physical plant are in good, clean, orderly condition and that you are using reasonably current and effective technology. No one wants to buy an old decrepit building with machines that need to be replaced or should have been replaced years ago. They will quickly see that as a large cash investment that needs to take place now and should have been covered by the previous owner. They will likely reduce their price accordingly and thus a business like that will not be as valuable as a company that has all new state-of-the-art equipment and technology and new office buildings.
Another item to consider is your supplier diversification. Having a few, concentrated suppliers that give you all the supplies needed to run your business can increase risk. So if you do have supplier concentration, either for a strategic reason or for other reasons, look to see if you can diversify or try to reduce risk if you can – for example consider signing a long-term contract with them if you have not already.
There are several items you will want to have documentation for when you begin preparing your business for sale. The first thing that would be beneficial to have is documentation of high customer satisfaction. This can be done through customer reviews, testimonials, feedback and review forms, etc. These server to show that reputation and brand you have established that will likely lead to strong repeat business moving forward. This is very valuable to a potential buyer.
Also, and in-line with some of the items we discussed in the operations section, you’ll want to have a written business plan or strategic plan that spells out the direction of the business over the next three to five years. This is valuable to a buyer because it shows that not only do you have a plan to grow the business but also, that you will likely achieve that plan because of your documented history of achieving your budgets and growth goals.
You should also make sure you have your financial statements from past years readily available. You’ll want to make sure these are accurate. They should have already been reviewed internally for accuracy and ideally, audited especially when you are within the last few years of your intended selling date. You want to make sure there are no surprises on your financial statements or in your accounts before you start doing due diligence with the buyer. Any error uncovered here buy a potential buyer will make them nervous about what else might be misstated or misrepresented.
Ensure that all of your corporate records are up-to-date and filed in an orderly manner that can be readily accessed. This includes the meeting minutes, reports from Board of Directors meetings, etc.
You’ll also want to review your customer contracts to ensure they are transferrable. This must be done so that the contracts don’t have to be resigned or renegotiated when the new owners take control. Look over these contracts with your business attorney to make sure this is covered. Likewise, you’ll want to review and/or sign written agreements with your key vendors, suppliers, leasers, or other strategic partners. Make sure that these agreements are also transferrable to the new ownership. This is all done to reduce the risk to the potential new owners so they don’t have to renegotiate all these agreements.
You want to make sure that you have employee non-compete and non-solicitation agreements in place so your key people don’t leave and set up a competing firm as soon as you sell your business. This again reduces risk to the buyer during the transition. Also look at implementing retention based compensation plans to help ensure that they will stick around after you have sold the business. Make sure that the compensation plans don’t pay out when the business is sold, since this actually increases the likelihood of your top employees leaving since they just got a large payout at the sale of the business. Design them to pay out well after your sale to encourage key staff to stick around to assist with the transition.
Another value driver is to keep documentation of employee reviews and show a history of employee development. This demonstrates a history of reinvesting in your people and indicates the company is dedicated to growing its employees, which likely means they will stick around since you’ve created a good work environment. A great work environment is also essential to attracting future talent to the organization.
This next one is a big one and is one of the hardest items to address in this list for most owners to address. You must ensure you, the owner, is not essential to the success of the business. A lot of business owners love doing the work so much that they are reluctant to relinquish their duties to the next generation of management and employees. They tend to hold on to the tasks that they’ve always done. For example, maybe they’ve always been the primary salesperson but they are reluctant to transition those key client relationships, or maybe they have historically performed the final review and sign-off on the work performed and are reluctant to transfer that responsibility. If you are going to try to sell your business remember what I keep saying, “nobody wants to buy your job”. You need to make sure you have a strong successor management team in place and that they have been trained on the key processes and procedures, and have been brought in to those key relationships, both with customers and with vendors, so those relationships stay intact through your transition.
In the same vein, you want to make sure you have clearly defined organizational leadership, and have current, written job descriptions for all positions within the organization.
These steps help to document how things are done, which is what lead to your success in the first place, and makes sure that it will continue after your exit.
This is just a short list of some of the key value drivers that you’ll want to start working on now if you plan to sell your business in the near future. Now, some of these changes can take quite a few years to address. Getting key metrics to trend in the right direction or show growth in customers over the last 3 years obviously takes time. Also consider that trying to get the right management team in place can take several years as well. That's assuming you find the right leaders on the first try. If you realize through the training and development process that some of your hand-picked leaders end up not being right for the job you envisioned them for, it can set you back at square one. Even for seemly smaller changes, they can take time. Anyone who has tried to implement any change in a business knows it never goes as quickly or smoothly as you hoped. There always seem to be unforeseen bumps along the way. Plus, you still have to run the business while you are doing all of this work on the business. Thus, the earlier you can get started on this the better.
If you’d like to learn more about these topics, please check out Augelli Consulting for multiple other free resources related to Exit Planning and value creation.
About the Author:
Jon Augelli is a licensed Professional Engineer, Certified Management Accountant, Certified Financial Modeling and Valuation Analyst, and the founder of Augelli Consulting, LLC. He has a passion for helping business owners achieve their dreams by growing their businesses and preserving their legacy. He does this by offering Fractional CFO and Exit Planning Services to small to mid-sized business owners across Southern Wisconsin. He has advised companies in a variety of fields including engineering, legal, healthcare, fitness, and e-commerce, and has navigated multiple business ownership transitions. For questions regarding topics discussed or CFO & Exit Planning services contact him at: firstname.lastname@example.org or 608-352-3332