Business owners considering an exit often want to know who their likely buyers will be and how much money those buyers are willing to pay. In order to forecast a realistic sale price, owners often look to standard metrics such as the ‘multiple of earnings’ – a valuation theory based on the idea that similar assets sell at similar prices. This way of thinking often leads business owners to the quick conclusion that the easiest way to increase their business value is to increase the earnings of the business. This newsletter examines that basic concept and challenges this conventional thinking by first asking the question, “Does the industry that you are in have the largest impact on the value of your business?”
Value is a Prophesy of Future Cash Flow
The most important concept in valuation is the idea that a future buyer for your business will pay you for the cash that they expect to generate from your business in the future. A prospective buyer will only write you a check for your business if they are confident that there is a ‘future’ for your company. The price and terms a buyer will pay are driven by the riskiness of the future, as they perceive it. There are three (3) important items to consider:
- Increased profitability will generally drive your company value higher.
- Reduced risk in your business will also drive your value higher.
- The industry in which you exist will produce willing investors who can best evaluate the risks of future cash flows.
In reality, in order for an owner to monetize their illiquid business, they need a buyer or investor willing to pay them for their future cash flows. Additionally, the industry the owner is tied to is one of the leading indicators of value, as it will determine how investors perceive the industry and are willing to invest in the future of that industry.
An Example of Industry Activity – High Growth vs. Slow Growth
Investments in different industries vary greatly. Some industries, such as technology, are fast growing and the competition is fierce. Technology can change the entire way that the human race receives, stores, processes and distributes information as well as how we communicate with each other. Look no further than your multi-purpose smart phone for evidence of these rapid changes. The technology industry attracts investors who see a tremendous amount of potential profit in the growing demand for new technologies.
By contrast, some industries – such as high-volume manufacturing (at least in the United States) – are slow growing, with many of the jobs in that industry farmed out to other countries where labor is less expensive. Investors are generally slow to approach the manufacturing industry because the prospects of future growth are often limited. Investors see risk in foreign competitors – driving down pricing and creating challenges for future, sustainable profitability and cash flow.
Many Owners of Privately-held Businesses Have a Niche
Despite these generalizations around certain industries, the fact is that many owners have ‘niche businesses’ within an industry. So, using the example above, while high-volume manufacturing may have uncertain prospects because of global competition, there are many niche manufacturers in the United States who operate at very high margins and have a lot of protection against foreign competition. Niche businesses generally provide a great income and lifestyle for an owner. However, when it comes time to seek an investor or a buyer, the question you should ask is, “Can your niche market be grown into a larger enterprise?” In other words, how much demand exists for your products or services? Can an investor see secure, future cash flows within your niche and industry as they look out to the future?
Will Your Niche Have Value to a Buyer in Your Industry
In order for a niche business to have the greatest value to a buyer or investor in your industry, it is important that you are able to demonstrate the following within your business:
- The business can run and grow without your active, daily involvement.
- There is an increasing demand for your products and services and projected activity within the target customers in your industry.
- Your company can meet these demands and you are able to provide a record of accomplishment – demonstrating that you consistently meet the changing needs of your target market.
If the elements listed above are in place, then your niche business may be attractive to an investor or buyer who will pay you for the future cash flows of your business.
While the day-to-day running of a business requires a myopic focus on management and execution, when you begin to move toward exit planning, we advise that you look deep into your industry in order to manage the largest determinate of value for your business. Once you have a solid understanding of activity and interest within your industry, you can begin to ask better questions about how you might cash in your business one day and begin thinking about how you can grow the business over the next few years to make it more attractive to an outside buyer or investor. We hope this newsletter generates some thinking around the valuation of your industry and provides you with a basic framework for applying value outside standard metrics such as income earned.