Scalability and business valuation

KEY ARTICLE TAKEAWAYS

Learn why buyers like scalable businesses 

Understand the factors that determine a company’s ability to scale 

Learn the pros and cons of creating a scalable business 

Decide whether scalability is right for you 

What is a Scalable Business?

A scalable business is a business that can grow revenues for the foreseeable future without having to make significant changes in personnel, systems,  processes, or infrastructure.

A scalable business has the right people in the right positions, has systems and processes that can accommodate additional workload, and has an infrastructure that can absorb significant revenue growth. 

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Why do buyers like scalable businesses?

Buyers are interested in one primary objective: maximizing the return on their investment. For most buyers, maximizing their return on investment will require that the business is able to grow revenues and profits after they make their investment. If a business does not have the right people, systems, processes  or infrastructure to be able to accommodate significant revenue growth, it will be harder for the buyer to generate their desired return on investment. 

Some buyers are comfortable buying businesses where they will need to hire a more qualified, deeper team, or where they must install new systems and processes in order to be able to grow the company. In fact, this is the investment thesis of many private equity firms: buy a company with good potential at a low valuation, hire experienced executives in key positions, revamp core business processes and systems, and then execute on a more aggressive growth plan. 

Because buyers must incur the expense and take the risk of each of these improvements to the business, they expect to buy businesses at lower valuations. Once they “upgrade” the business so that it is more scalable, they will be able to sell it for higher multiples of EBITDA.  

However, if you as an owner have done this work prior to your own sale, you will be able to attract a higher valuation for your company because buyers will know they can get started on their growth plans immediately (versus having to wait to build a better “engine”).  

What factors inhibit scalability?

There are several ways a company’s scalability could be impaired. The first and most important is people. If the business relies heavily on the owner for its operations, sales, product development, and/or customer relationships, it can grow only as far as the owner’s individual capabilities. This explains why so many businesses reach their ceiling of success at around $10 million in revenues. To grow beyond this level requires having a deeper team, which many business owners have not been able or willing to build.

Second is systems and processes. A scalable business must have systems and processes that are trainable for new employees, that can be measured and managed with appropriate data, and that can be consistently executed over time to create predictable results. Businesses that rely too much on individual  expertise and experience will not be able to grow beyond the capabilities of those individuals. Without systems and processes in place to train new employees, the company’s growth will be limited.

Systems and processes also include being able to collect, produce, and analyze the right information and data required to manage the business.  A scalable business will utilize technology to help speed the flow of information across the business, enabling managers to make informed decisions. An antiquated accounting system or the absence of an enterprise resource planning (ERP) system will limit a company’s ability to grow. 

Similarly, the infrastructure of a business (its facilities and equipment) can serve as a brake on growth. For example, a craft brewer will not be able to grow revenues beyond the capacity of its current brew house and canning/bottling lines, and a waste hauling company will not be able to grow past the capabilities of its current fleet of trucks.  

Expanding infrastructure can require significant capital investment. If your company has not made the required infrastructure investments for future growth, then a buyer will need to do so. As a result, your valuation will be reduced not only by the expected cost of this investment, but also by the level of risk involved in making these changes. 

Do you really want to create a scalable business?

Before identifying how to create a more scalable business, many business owners first need to answer the question: do I want to create a scalable business, or am I more comfortable and content with a "lifestyle" business?

There are pros and cons of building a scalable business. Let’s start with the pros. 

The advantages of a scalable business

Building a scalable business means you will create a more valuable business, and therefore generate a higher return on your investment of time, money and energy. It will deliver greater financial returns to you, creating more options for you later in life.  

Scalable businesses also mean you will have a team to manage the business, which creates more time for you to focus on activities inside and outside the business that you enjoy most. This means you could decide not to sell the business because you have the life you want today, while still owning the business and generating nice cash flow. 

A scalable business will have less operating risk than one where scalability is limited, which will help you sleep better at night (not worried that if you get sick, the business will fall apart). For many owners, this peace of mind is attractive. 

The trade-offs of building a scalable business

What about the trade-offs of investing in a scalable business? 

For many companies, the founder started the business as an expert in the field of doing whatever the company does – professional services, manufacturing, software development, etc. Based on the founder’s expertise, successful companies deliver value for their customers, at least until the founder/owner’s capacity is maxed out, at which point the company either stops growing, or starts to deliver sub-par customer service or products (which will also cause growth to stop). 

For many owners, hiring a team and trusting them to do the work of the business is uncomfortable. They might not have had any experience building or managing a team, and they might not trust that the team will do the work as well as they could do it themselves. We see countless examples of an owner believing that they are the only person capable of performing the work they do at an acceptable level.

Not having prior experience, and not “knowing” that a team could possibly operate at a higher level than the owner, makes the decision to hire a team appear risky to the owner. This is understandable. Hiring a great team is challenging and an owner will often encounter setbacks when they make a poor hire.  Moreover, some owners suffer from a feeling of “losing control” once they are no longer the one designing the product or delivering the service – this can be disconcerting. 

In addition, the investment in a deeper management team, new systems and processes, and better infrastructure also carries risk. Rarely does a company escape this process without some battle scars. It is challenging to do each of these things right, and you will most likely make some costly mistakes along the way. Some owners would prefer not to take these risks. 

Creating a scalable business also means that the owner’s role will change over time from being the principal “doer” to being a manger to ultimately being a leader and strategist. For some owners, this transition is not a comfortable one, or frankly even one they want to make. They might prefer to simply be the “doer” as the work they do is the work they enjoy – they don’t  want to manage a large organization, all of which is perfectly acceptable. 

How to decide if you want a scalable business?

As an owner, you need to decide whether you want to make the investments and take on the risks of building a scalable business. Straddling the fence is the worst outcome – if you are secretly uncomfortable delegating or losing control, but hire a team of competent executives, you will likely lose time, money and energy while you micro-manage them and drive them away. Investing in new systems and processes that you are not comfortable with yourself will undermine their effectiveness. 

We advise owners to think about what is most important to them – having the life they have today where they control a lot of what goes on in the company, or striving to create something bigger. There is no right answer, and for many owners, the most appropriate decision for them is to simply maintain their lifestyle business.

However, even for owners who don’t want to hire a team and delegate portions of their job, in order to have a sustainable business they will still need to make investments in appropriate systems, processes and infrastructure. These investments can be moderated if they are not required to scale past a certain revenue amount, but in order to have a business that can last for the owner’s desired timeframe, they will need to invest in these systems.

If you want to build something greater than yourself, and enjoy the benefits of having a scalable organization, including making your company much more valuable, then investing in team, systems, processes, and infrastructure are the right next steps. It will challenge you, make you uncomfortable, force you to adapt to a new role, and teach you important lessons, but in the end, if you are successful, it will create more opportunities for you and for your team.

One final note on timing. Most owners wait too long to decide whether they want to sell the business or not, and miss opportunities to properly plan. If you have decided that selling is part of your plan, you should start planning as soon as you can. Otherwise, you could get caught in a situation where you get sick, burned out, or approached with “an offer too good to pass up” but you won’t be prepared for the transaction. This will not only decrease the value you ultimately get, but could reduce the odds of any deal actually closing. Time is of the essence.

If you’d like to learn where your business today might have challenges scaling, click on the button in the red banner above to take our CoPilot Assessment. CoPilot will help you identify if your company is too dependent on you, your systems or processes are lacking, or your infrastructure is inadequate for future growth.

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.

** A special shout-out to Cindy McDaniel, who is a Vistage Chair in St. Louis, who helped us with this article. Like many Vistage Chairs, Cindy has a unique perspective on what makes for good businesses having mentored and coached so many of them over the years. Thank you, Cindy – your contributions and feedback were invaluable!

AUTHORED BY:

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.

The views expressed represent the opinion of Class VI Partners. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness.  While Class VI Partners believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and the Class VI Partners view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Testimonial may not be representative of the experience of other customers. Testimonials are no guarantee of future performance or success. Testimonials are NOT paid testimonials.
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