According to Inc. Magazine’s “The Most Valuable Company in America”, it is likely that 10 million small companies will be sold in the next five to ten years. Because of this development, many of our clients regularly approach us to discuss business valuation and ideas for transitioning their businesses. As you likely know, there are countless considerations when transitioning your business to either family members, employees or through a sale to a third party. One important consideration is determining how to enhance the value of your business before the transition. So let’s examine two strategies: decreasing your business’ risk profile and improving your cash flow.
Decrease the Risk Profile of Your Business
Value is a function of the predictability of future cash flows and the risk associated with achieving those cash flows. This means that a riskier investment will require a higher expected return (i.e. cash flows) than a less risky investment, all other things being equal. Therefore, one way to increase the value of your company is to decrease the risk associated with achieving its expected cash flows. Sounds pretty simple – but how does an owner decrease the risk profile of his or her business?
Diversification – Whether we are talking about products, customers or suppliers, it is almost always preferable to diversify. Diversification provides the business alternatives if it is faced with unfavorable external challenges, such as the loss of a large customer, the bankruptcy of a supplier or the entrance of new competitor for a given product line. Of course, such issues may hurt the business’s value, but diversification allows the company to soften the blow. Furthermore, a diversified company is better positioned than its undiversified counterpart to recover from these events more quickly.
Stabilize Revenue and Cash Flow – An investment with a stable, predictable cash flow stream typically suggest a lower risk profile than an investment that has less predictable cash flow and volatile returns. This is why we see much lower rates of return on debt investments (such as bonds) compared to an equity investment. This is not to say that an investment in a company with stable cash flows is more valuable than the riskier, more volatile company based on the fact alone (there are many more factors at play, of course).
Nonetheless, by exhibiting a stable historical cash flow pattern, the company adds reliability and predictability to its risk profile, which decreases the risk associated with an investment, thereby making that investment more valuable and appealing. Stable cash flows are often the result of good diversification. For example, a company that only does snow plowing is susceptible of variability in cash flows based on weather. A harsh winter will bring higher cash flows while a mild winter will result in weak cash flows. However, if the company offers other services, such as landscaping or contract work, the volatility in snow plow cash flows is not as severe to the overall business because of the other revenue streams brought about by diversification.
Build a Strong Bench – Like customer or supplier concentration, many small business have higher risk profiles due to “key man” issues. These issues often stem from a single owner-operator’s far-reaching responsibilities in running the company, and the company’s overall reliance on an owner-operator’s personal relationships with key customers and suppliers. The business can reduce this risk by building an executive management team that can provide stability in all facets of sales and operations should an untimely departure of the owner or other “key man” occurs, whether voluntarily or involuntarily.
A business that can be turned over to a buyer and does not require the seller to keep working in the business will often be worth more than one that is heavily dependent on the seller’s continued involvement. The importance of this issue cannot be understated. In many cases, a Company having a good management team is the most important factor in the success of any given business transition. For instance, discussion regarding the quality of the ‘management team’ is one of the primary areas that private equity buyers focus on when considering an acquisition.
Create Repeatable Systems and Processes – Like the three mechanisms we discussed above, the existence of recognized and repeatable systems and processes adds stability to an organization. Companies can insulate themselves from employee turnover by implementing processes that can be easily transitioned among the work-force. In addition, companies that have strong systems and processes typically have more efficient operations, which translate to higher margins and stronger cash flows.
The value of your business can be enhanced dramatically by managing the risks that the company faces. While many components of a company’s risk profile are outside of the owner’s control (economic factors, industry factors), addressing the issues outlined above well in advance of a transition can make a significant difference in enhancing a business’s value.
Improve Available Cash Flow
The second input to the valuation equation is the expected investment return of the business. Therefore, enhancements to a company’s cash flow (or any input to cash flow, such as improved revenues or reduced expenses) will also increase its value. Quite simply, the company that makes more money is going to be more valuable, all other things equal. Often times business advisors state the obvious such as ‘you need to increase your revenues’ or ‘you need to grow your profit margin’ yet many times these advisors do not have enough knowledge or your business or industry to give specific advice on how to achieve these recommended actions. In reality, if it was easy to grow revenue, increase profit margin and increase cash flow of the business, you’d probably be doing it! There is no single recipe for business owners to use to help them increase cash flow. All businesses have different facts and circumstances that impact their cash flow. But there are a few areas that we recommend that will help business owners with managing and improving their cash flow:
Budgets – spending time to put together month by month budgets each year that are compared to actual results on a monthly basis pays off! This process helps you understand what expenses are actually needed to run the business and helps set revenue targets necessary to achieve bottom line results. We have found that this simple process can often times help a business owner set and achieve cash flow goals.
Financial Analysis – analyzing how your company compares to its peers within the industry can be a real ‘eye-opener’ for a business owner. There are various sources to find industry data that can be used to create a financial analysis for most any business. This type of analysis can highlight areas your company is underperforming its peers. For instance, if the industry data shows gross profit for your business should be 25%, and your business is at 20%, as a business owner you now have identified an area that you may be able to improve your cash flow.
Empowering Your Employees - tailoring employee compensation to productivity or performance-based results, whenever possible, often leads to improved profitability and cash flow. There are many different ways to employ performance based compensation plans, but in its simplest form you set targets for your employees (based in some form on your overall company budget/goals) and if those targets are met your employees make more money and so do you!
While it seems quite obvious, improving your company’s revenues and controlling its expenses have a direct impact on cash flow, which is a primary driver of the value of your business. Many of the methods to enhance cash flow that are discussed above have the extra benefit of reducing your business’s risk profile, so it is certainly worth exploring ways to implement these ideas.
While the factors discussed above can have a real, tangible impact on the value of your business, there are other potential “fixes” that are often not worth your time and attention. Nonetheless, we still see these ideas implemented in the hope of enhancing value. This is not to say that they have zero impact on value, but that they may not have the “bank for your buck” that other changes to your business may have.
Adjusting Owner Compensation –It stands to reason that if you take less money out of the business in the form of compensation, you will show improved margins and cash flow. This is true. However, a valuator will look at this from the prospective buyer’s perspective and adjust compensation to a reasonable level (based on the services you provide to the business) in determining the company’s value. It should be noted that by reducing your compensation, you are able to leave cash in the business, the result of which might be a stronger balance sheet or an opportunity to invest in new projects, both of which may increase the value of your business. However, simply reducing your compensation without pulling any of these other levers will likely leave your value in the same spot it was in before you adjusted your compensation.
Paying Down Company Debt– This one is a bit tricky because it depends on your perspective. We like to use the analogy of purchasing or selling your home when explaining this concept to our clients. Your mortgage balance has no impact on a value of your home. If you were to pay off your mortgage tomorrow, the most likely sales price of your home would remain unchanged. Furthermore, you have less cash in your pocket than you did prior to paying off the mortgage. What is important to note, however, is that the amount of cash that lands in your pocket when you sell the home will most certainly change because you no longer have to pay off your mortgage.
Essentially, the cash you used to pay down your debt is refunded to you at closing – like the cash has been moved from one pocket to another. So, when we say that it depends on your perspective, we mean that you need to understand the difference between the value of your business/home (we call this “enterprise value” in the valuation world) and the amount of cash that is leftover after you pay off any bank debt (we call this “equity value”), as these can be very different numbers. Ultimately, the value of the business stays the same – all you are doing is changing the character of your financing between equity/debt and how much cash you have inside and outside the business. We have touched on just a handful of ways to enhance the value of your business. It is important to understand that the value of your business today is only relevant to the extent that it serves as a starting point of your transition plan. Today’s value may bear little resemblance to the value of the business when you are ready to enter into a sale transaction. As you can see, approaching your transition with an organized, clear plan that implements value enhancement opportunities will pay off in the end.
We work to simplify complexities, help make critical business decisions, and confidently focus on the things that are truly important to you. We embrace your business as our own to spark the right solutions and help you thrive.