KEY ARTICLE TAKEAWAYS
Learn what makes a company valuable
Identify different strategies your company can deploy today to increase company valuation
Understand why increasing your company valuation is important regardless of whether you intend to sell your company
What makes a company valuable?
Business valuation is ultimately determined by the value of all the estimated future cash flows a business will generate (plus the expected value the company will get when it sells), discounted by what is called a “discount rate”. A discount rate is an estimate of how risky the company’s future cash flows are.
Companies whose future cash flows are less predictable and perceived to be riskier will have a higher discount rate and a lower valuation than companies whose future cash flows are highly predictable and are perceived as less risky.
Want to get a sense for what it takes to sell your company? Start with this exit checklist.
As a result, companies can increase their valuation by doing two things. First, increase the expected future cash flows from your business (this comes from having a robust growth plan). And second, decrease the level of perceived risk in your future cash flows.
What can you do today to increase your company’s valuation?
There are dozens of strategies for increasing the valuation of your company, but we will focus on 7 of the most effective.
1. Build a robust, defensible growth plan.
A robust growth plan will look at every driver of revenues, expenses, and capital investment over a 2-3 year forecast period (by month) and have support for each of the assumptions made in the plan. For example, a robust growth plan will build sales up by salesperson over time to see if the assumptions going forward (sales per salesperson) are consistent with what the company has experienced in the past. This is true for every line item of your income statement and balance sheet. If you need a template to build a growth plan, please reach out to [email protected], and we can provide you one. They take time and require deep analysis to build correctly. Obviously, having a strong record for growth in the past will make any growth plan believable. The least believable growth plans are from companies who have grown at 5-10% per year for the last 5 years but are showing a growth plan at 20-30% going forward. No investor will believe that plan without significant analytical support.
2. Build your management team.
Most mid-market businesses are too dependent on the owner for their success. In many companies, the owner is responsible for overall operations, or is responsible for most of the company’s sales or customer relationships, or is the creative mind behind product development. Having these critical operations of the business depend heavily on the owner simply means the company’s future cash flows are very risky – they could be significantly interrupted if something happens to the owner.
3. Diversify your revenue and lead sources
Many businesses have more than 20% of their revenues coming from one customer, or more than 50% of their revenues coming from just their top 5 customers. This creates significant risk in the company’s future cash flows. If something happens to that customer or the company’s relationship with that customer, the company’s future cash flows will be significantly disrupted. The same is true for your lead sources – if your company gets most of its leads for new business from a single source, losing that lead course will also be highly detrimental to your company’s future cash flows. Build your business so that no more than 5-10% of your revenues come from any customer or lead source and your business will become less risky and more valuable.
4. Drive greater predictability in your revenues.
One of the reasons software-as-a-service businesses (“SaaS”) are so valuable is because their revenues are building each month and are highly predictable going several months or years into the future. If you are able to build repeat or recurring revenue streams from your customers that are highly predictable going into the future, you will make your business much more valuable.
5. Build a “moat” around your business.
Warren Buffett likes businesses that have adequate competitive “moats” – in other words, their revenue streams and customer relationships are well protected from competition. How can you do this? There are several ways: having products that are protected by patents or other intellectual property protections, exclusive distribution rights in a particular geography, long-term contracts with your customers, strong consumer brands, high barriers to entry for competitors, high switching costs for your customers, etc. These take time to develop, so as you are building your business, give serious consideration to how you can better protect your revenues and customer relationships from competitors.
6. Build a strong track record of profitable revenue growth.
Although the warning from most mutual funds is that past performance does not guarantee future success, in business having a strong track record of generating profitable revenue growth will decrease the perception of risk in your business.
We had a client whose revenues grew between 13-15% each and every year for the last 15 years, and profits grew at 16-20% per year, each and every year. As a result, it realized a multiple on EBITDA that was far above industry averages.
7. Clean up your books and records.
This seems to be unrelated to profits and revenue growth, but when dealing with professional investors, first impressions are important. If your books and records are a mess and hard to navigate, investors will perceive that the rest of your business is also operated in a sloppy way, increasing their perception of risk in your business, and therefore decreasing its value. Having a great first impression by having audited financials, contracts organized, clean corporate records, and easily accessible financial information will lead investors to believe you have your act together and run a tight ship. This will increase your company’s overall valuation.
What if you never want to sell your company – does company value matter?
Some business owners don’t plan to sell their companies. They want to transfer the business to their children, management team, or maybe an ESOP (Employee Stock Ownership Plan). Should they focus on increasing the value of their business with the 7 steps outlined above? Absolutely.
They also make the business much less risky for their children or employees, making it more likely they will succeed once they take over the operations of the business.
There is probably no worse feeling for an owner of a business than to see their creation fail in the hands of their kids or employees. So, spending time on these initiatives to make the business less risky will dramatically reduce the odds of a failed business once it has been transitioned to their kids or employees.
Each of these initiatives takes time and energy, but they will be well worth it. If you think you might need some help putting your strategies together, please feel free to reach out to us at [email protected].
If you’d like to learn more about how your business is currently positioned with respect to the areas outlined above and dozens of other potential risks, click the red banner above to take our CoPilot Assessment. CoPilot will help you identify what specific risks your business has that decrease company value. CoPilot identifies over 90 different types of potential risks your company could have that will make your business less valuable in the eyes of an investor. Get the test ahead of time and build value today with CoPilot.
Bobby Motch | Associate | Class VI Securities, LLC
As an Associate at Class VI, Bobby has experience in transaction execution and board advisory services for clients in a variety of industries, including consumer products, food and beverage, business services, software-as-a-service, manufacturing, and distribution. Additionally, Bobby contributes to the development of Class VI’s CoPilot services and Class VI content creation.