Most business owners at some point in time want to know the value of their privately-held business. Further, many owners who see their ‘exit’ as being many years in the future would like to know what they can do today to improve and grow that value. This newsletter asks a rather simple question for owners to consider today, “is it better to increase your profits or to reduce your ‘transition risk’ in order to increase the value of your business?”
The Risk and Return Formula For Valuations
A buyer of a business will pay for the cash flows that they believe will happen in the future, which is measured by the overall riskiness of those forecasted cash flows being achieved.
Let’s translate this a bit further. A business is worth what someone else is willing to pay for it – that is the ‘price’ at which a business may sell. However, the ‘value’ of a business today can only be measured using certain specific ideas about how a future buyer would view the business. As a general rule, buyers will pay for future cash flows but only at a rate at which the riskiness is properly reflected. Therefore, a complete analysis of how to increase the value of your business must include both increasing profits (i.e. cash flows) as well as analyzing and reducing risks in the business.
Many owners are familiar with ‘industry multiples’ for sales of businesses. For example, many owners will understand what it means when someone says that “Jim sold his manufacturing company for ‘5 times’ the company’s earnings”. The ‘5 times’ is simple to understand. Jim’s company, in this example, had a certain amount of annual profitability and the buyer of Jim’s company paid 5 times that number. For example, if Jim’s company had $1 million in annual profit, the buyer paid $5 million for the business – simple enough.
Increasing Profit as the Default for Increasing Value
Using the example above, many owners in the same industry as Jim will forecast a realistic sale price for their own business by looking to these standard metrics such as the ‘multiple of earnings’ under the theory that similar businesses (i.e. their business) will sell at a similar price. This often leads business owners to the quick conclusion that the easiest way to increase the value of their business is to increase their own company’s earnings. Why wouldn’t an owner think in this logical way?
However, the question that is less frequently asked is “what is comprised of the ‘5 times’ multiple and does my business have the same risk factors as Jim’s in the example above?”
Deriving a Multiple from the Risk Factors in a Business
To understand multiples, one must first see that a buyer is paying a certain multiple because of their perceived riskiness of the future cash flows of that business. There are many factors that impact the riskiness of a business and, therefore, impact the value.
For example, lets assume that Jim had a solid management team in place and only worked in the business one (1) day a week. When a buyer sees that they will gain access to the same management team when they purchase the business, they see less risk in the transition of the company and that element factors into the multiple that they pay. Whereas if you are running your business by making day-to-day decisions and taking little or no vacation time, most buyers will see more risk because you represent a single point of failure for the business. In this case a buyer would see more risk and would, therefore, pay a lower price – all things being equal.
So, in an attempt to answer the primary question in this newsletter, one must ask themselves whether it is easier to increase the profitability of your business (i.e. grow cash flow) or is it easier to staff the company with an initial quality manager or two in order to reduce the risk?
There is no right answer to this question. However, this newsletter is written to challenge your conventional thinking about increasing the value of your business.
Other Risk Factors that Impact the Multiple
Let’s assume that you are of the mindset that it is easier to hire a manager or two than it is to increase your company’s profitability over the next few years. You might then be asking what else you can do to reduce the riskiness of your business in order to increase the multiple that you may receive. Here are a few items:
- Improve the quality of your financial reporting.
- Reduce customer or vendor concentration.
- Have a clearly defined, written strategy for company growth that is shared with others in the company.
- Improve your procedures and operations manuals.
- Document and execute on dynamic marketing and selling programs.
These are just a few of the ‘non-cash-flow’ components of your business that will reduce ‘transition risk’ and will help you to increase the value of your company.
Reducing Risk is About More than Increasing Value Alone
Hopefully by this point in the newsletter you are seeing that there are many factors that go into the value of a business and many ‘risk reducing’ measures that can be taken to increase your value.
That being said, it is important to also point out that reducing risk is not just about increasing value, it is also about making your company more saleable overall. You see, if a buyer sees too many risks in your business it is just as likely as not that they will walk away from the transaction as opposed to reducing the overall purchase price. Many buyers don’t want to fix a business that they consider broken – it’s easier for them to find one that has less risk and is easier for them to run profitability in the future. The translation is that by ignoring risk and only focusing on increasing profits, you might actually scare buyers away, therefore eliminating the ‘gains’ that you felt you would achieve by simply increasing your profits.
Every business owner will one day exit their business. Some will get paid top dollar while others will spend years trying to ‘get out’. This newsletter attempts to make the point that it may be easier, cheaper and more efficient for you to focus on reducing risk before jumping right into the process of trying to increase the value of your company by growing profits. We hope that this newsletter has you thinking more about your future exit and what you can do today to increase the success of that future transaction.