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.
No comments:
Post a Comment