Journal

Feb 12

Preparing to Sell Your Business – Step Seven: Improving Value Drivers

Journal entry by steve, Feb, 12 2015

 

This series of articles examines the steps that a business owner should walk through in preparing for a business sale transaction. To request a copy of the full series to date, please contact michelle@piedmontbusiness.com.

 

Step Seven: Improving Value Drivers

Most people expect sellers to value a business on the high end and buyers to value a business on the low end. Some of this may be a product of negotiation posturing, sellers knowing that a buyer is not going to pay the full asking price, and buyers thinking that anything should be bought for less than asking price. Perhaps the first rule of negotiating is to leave room to negotiate. Interestingly, though, seller’s accountants generally tend toward overvaluing a business in comparison to market transactions. Buyers’ accountants will most often be of the opinion that the seller’s accountant has overvalued the business, and recommend a lower value to their client. To some degree this may be a function of advocacy, but another element is likely at play, and that element is perceived risk.

Most businesses are valued in the market based on some measure of their cash flow or profitability. In some industries “rules of thumb” for value have developed based on a multiple of revenue, but these are really just a proxy for earnings. It may be said that an accounting firm will typically sell for 90% of annual revenue, but ultimately it is the expected cash flow of a firm that will be important to a buyer. Accounting firms with the same annual revenue figures will be worth more or less depending upon their profitability given the infrastructure, people and processes they have in place.

If a measure of cash flow is used to value a business, once cash flow is determined the million dollar question is this: what rate of return is appropriate for the investment? If an investor requires a 50% rate of return on a small business investment because of the perceived risk, then she will only be willing to pay $500,000 for a business generating $250,000 owner cash flow. This is a high rate of return, but within the range of reality for certain types of small businesses when the buyer will be required to work full-time in the business. The reality is that the buyer does not know the business nearly as well as the seller, and therefore perceives far greater risk than the seller. Accountants tend toward conservative when advising buyers, and often perceive even more risk than the buyer – thus recommending a higher rate of return and a resulting lower valuation. Sellers and their long-time accountants know the business very well, have seen it succeed over a number of years, and think that it cannot fail. They reason that perhaps a 20% rate of return on the investment is fair to the buyer, and thus the business in the example above should be worth $1,250,000 (or five times cash flow).

Market comparisons of completed transactions and buyer reality check presentations prove useful in bridging the gap between seller and buyer. Ultimately, though, it is cash flow that drives value. If a seller and a buyer ultimately agree to a value at three times cash flow, the business with $250,000 cash flow can increase its selling price by $300,000 by increasing annual cash flow by $100,000. While last year’s performance may not be conclusive to a buyer, there is a strong tendency in the market to believe that last year’s cash flow will be repeated and that revenue trends – positive or negative – will continue on a similar trajectory. So a single year of focus on increasing cash flow can prove valuable at the time of sale, and a 2-3 year record of strong cash flow (documented with professional financial statements and consistent tax returns, of course) will be difficult for a buyer to dispute.

Knowing that improved profitability will yield a significantly higher price at the time of sale, it is incumbent upon the owner contemplating a sale of the business within a few years to evaluate value drivers. As we are using it here, a value driver is anything that can be done to improve cash flow and increase company value. Some adjustments are simple and have been discussed previously, such as cleaning up the financial statements to include all revenue and eliminate non-essential expenses. Other value drivers are more complicated, and may require investment in new equipment, personnel, or systems. While the owner is typically in the best position to understand the business, outside consultants may provide a fresh perspective and new ideas.

Improving value drivers takes time, and some business owners simply do not have time to improve the business before selling. It is still a worthwhile exercise to think through the ways in which the business can be improved, perhaps with additional capital or personnel, or access to a new customer base. The owner should document any ways in which profitability could be increased, if the owner only had the time or resources, and exactly what would be required to achieve those objectives. At the same time it is important to be able to explain the reasons why the owner has not pursued those opportunities. Buyers are not likely to pay much more for a business based on the owner’s unimplemented plans for increasing profits, but the information can be useful for identifying strategic buyer opportunities, or perhaps improving the perceived value of the business to a buyer.

 

Coming Next – Step Eight:  Identifying Likely Buyers

 

Stephen C. Minnich, J.D.
Certified Business Intermediary
Piedmont Business, LLC
(336) 202-7905
www.piedmontbusiness.com

Comments are closed.