What creates business value?

I was thinking the other day about the 3 key financial results areas for all businesses – profit, cash and value.  The first two are really easy to work out, but the last one is never apparent from any financial reports – you have to get someone to do the exercise for you.  Further, there seems to be a bit of a myth that valuing a privately owned business only needs to be done when the business is ready to be sold or when a lender requires a valuation as part of a due diligence programme.  If business valuations are only undertaken at one for those trigger points then you can be certain that the critical business and estate planning issues have not been fully addressed.

There are also a number of myths surrounding business valuations, and we’ve heard them all.  The most common ones are “businesses in my industry always sell for 2x earnings, so it’s really easy to work out” and “John from down the road sold his business for 3x sales 6 months ago, and mine must be worth at least that”

Valuing a business at the best of times is an inexact science – in other words, an art.  We know that smaller middle market companies historically fall between 3 to 6 times profit, but how do you know which one is relevant for your business?  If you looked at a company with profit of $500,000, then the business is probably somewhere between $1.5M and $3.0M.  But what causes it to be closer to one end of the range instead of the other?

The business value multiple is quite simply a reflection of the relative risk of an industry as a whole.  The higher the perceived risk of the industry, the lower the profit value multiple.

We have come across free online business valuation calculators, but these come with so many disclaimers that they are not overly reliable.  We tested one out recently for a business that we valued at $1.1M.  The calculator came up with a business value of $870,000 – great if you’re the buyer, not so flash if you’re the seller.  But it at least gives an idea of where you would sit if you used an industry average.  There are five fundamentals will determine whether your business is better or worse than industry average.

1. Barriers to entry.  The harder it is for new entrants to come into your market, the greater the value of an existing business.  Any critical intellectual property needs to be properly safe-guarded.  This can also include the ease with which customers can change their suppliers – the higher the switching costs, the better the business multiple.  Except, of course, if there is a paradigm shift in the industry – the internet has changed the way we all do business, and it hasn’t finished yet, baby.
2. Size and growth opportunities.  Size really does matter.  The larger a business, the more likely that they have a number of different income streams, a greater number of customers and greater breadth of talent amongst their employees.  Being able to increase the number of profitable income streams, while still maintaining focus on the core business area always increase business value.   It is possible to be a small business by operating in a niche market or by controlling access to specialised products or services.
3. Management.  The key to good business management is not being over-reliant on key members of the team.  If management is taking care of business, then any buyer is likely to get excited.  This is one area where larger businesses will always win out over smaller players because the level of dependence of a few key people is minimised.  And while you’re at it, if you are dependent on key employees, do make sure that you have them insured.
4. Industry benchmarks.  Any business that is doing better than the industry average is on to a winning strategy.  If you’re firing on all cylinders then your business becomes really attractive.  It can be difficult at times trying to get access to benchmarks, but that will become less difficult as information becomes cheaper and more readily available.
5. Customer reliance.  A small group of major customers who provide most of the income and profit is clearly a danger signal.  Not only are they in a position to strongly influence the business profitability, they can also get to the stage of determining the terms of trade.

When we’re doing business valuations, we look at the five fundamentals of business value, using a business risk and value driver assessment tool.  And the good thing is, not only does it assist in determining the best price multiple for your business, but it also highlights the areas of weakness so you then have the opportunity to improve your business value.