Wednesday, August 8, 2018

Driving the Valuation Multiple Higher

At its core a business’ value is simply the historical cash flow times a MULTPLE.  So, given an historical level of cash flow, how does a business owner increase the multiple that is applicable to his or her business?  First of all, it is important to understand that imbedded in this MULTIPLE are a multitude of factors about the business, the industry the business operates in, and the overall nature of the economic environment that affect the risk profile of a particular business.  Lower risk of ownership equates to higher valuation multiples and vice versa.  So, the key to increasing the multiple applicable to your business is to reduce the risk of ownership. 

Let’s explore what makes some companies worth only 4X cash flow while others are worth 7 – 8X or even more.  The key is to reduce buyer risk.  A more confident buyer is a more generous buyer and a less risky deal is a more highly valued deal.  Here are some of the factors that can reduce risk and increase the valuation multiple.

Quality of earnings is probably the most important factor for any buyer.  A history of consistent, reliable earnings can go a long way in making the potential purchaser comfortable that they can count on the historical level of earning continuing in to the future.  One of the factors that impacts this consistency of earnings analysis is the type of revenue generated by the business.  Revenue generally comes in one of three types; project based revenue, repeat revenue and recurring revenue.  When revenue is project based, each time a project is completed a new customer or project needs to be identified and won in order to continue the revenue stream.  This is the least valuable type of revenue.  Repeat revenues is characterized by a stable set of customers who do place repeat orders but there is no real certainty as to when the next order will be replaced.  The best way to describe this is a business with a loyal customer base.  Obvious examples of recurring revenue models are cable TV companies or home security monitor companies where the customers’ payments repeat periodically (typically monthly) and are frequently on auto-pay.  Ideally customers do not have to make a purchase decision every month.  The purchase is automatic.  To the extent a business can move from project base revenue to repeat or to recurring, they will see an increase in their valuation multiple.

Consistent positive trends will also have a positive impact on the valuation multiple.  Whether this consistency is in revenue growth rate, profitability margins, asset utilization or required annual capital investment, consistent trends reduce risk and increase the multiple.  Any volatility in any of these area increases risk to the potential buyer and reduces the valuation multiple.  I have frequently said that growth rates do not have to be large; but that slow steady growth rates are much more valuable than a large increase in one year followed by drops in the next.  Consistency is critical to value.

An established management team that does not rely heavily on the existing owner is one of the most important things a business owner can do to assure a potential purchaser that the business has a high probability of continuing on without a hiccup after a purchase.  By having a professional management team in place, the buyer has every reason to believe that the critical functions of the business will continue even after his or her purchase. 

Diversification is also critical to reducing risk and increasing the valuation multiple.  When you stop and think about it, we have all been taught to invest in a diversified portfolio to reduce risk.  The same principle applies here when preparing a business for sale.  For business owners, diversification can be a factor in many aspects of their business.  Two of the most common areas where diversification is a focus include the customer base and the supplier base.  Nothing hurts valuation multiples more that large customer concentrations.  The risk of losing one big customer or having one of your critical raw materials controlled by a single vendor can have a huge negative affect on valuation multiples.   

Well documented systems and business processes will also reduce the transition risk for a new owner and will increase valuation multiples.  To the extent that a selling owner can demonstrate they have a well-documented selling system, an established supply chain, well-documented procedures for hiring and on-boarding new hires, that they have key performance indicators (KPIs) that are monitored and drive action, and have up-to-date IT systems, they should be rewarded with a higher valuation multiple. 

Asset quality is also an important factor in increasing valuation multiples.  Companies with high quality accounts receivable (no collection problems), inventory that does not include any stale or obsolete inventory and that consistently invests fixed assets should see higher valuation multiples.  Businesses that have a high degree of deferred capital expenditures will see their valuation multiple depressed.  

Companies that can protect their market position with intellectual property should also benefit from higher valuation multiples.  Buyers are always interested in the barriers to entry that a company can create to keep competitors at bay.  To the extent that a business has patents, trademarks, copyrights or even trade secrets, they will be seen by potential buyers as reducing risk and should result in higher valuation multiples. 

Lastly, size can be a critical factor in reducing risk for potential buyers.  Universally, buyers perceive larger business enterprises as having a better chance of surviving threats from competitors, dependence on single vendors or even the negative affect of economic downturns.  To the extent that a business owner can continue to grow their business, they should be rewarded with higher valuation multiples.

Reducing the risk of acquisition as perceived by the buyer is critical to increasing valuation multiples.   

Alan D. Austin, CFA

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